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Betting on Retail Risk Management: Flat Prices for Peak Hedging

Why a risk-hedging product for small customers isn't the gamble you may think.

Fortnightly Magazine - November 1 2002

Some innovators in the electric industry recently began offering financial hedging products that absorb risk from large customers. Why not offer this kind of protection to customers with small electric loads?

Flat pricing is not flat rates per kilowatt-hour, nor is it a budget bill program. Such common products help customers to levelize monthly bill variance, but do not actually protect customers from price and billing risk. Protecting customers from price risk is the essence of flat pricing, and it is where a company can step in and capitalize.

The flat pricing concept is not rocket science. In fact, it isn't even considered innovative. Many industries, including some that are similar to the electric industry, use it as their pricing strategy of choice. Capacity-constrained Internet service providers quickly moved from volumetric pricing to flat bills early in that industry's history. Another industry with capacity constraints, the cellular phone service market, has evolved from pure volumetric pricing to a more customized menu of flat offerings. Even the volatile retail gas market has been experimenting with its version of residential flat bills.

Sure, you might say, it's fine for other industries, but not for the complex and dynamic electric industry. System capacity would become inefficient and unmanageable; peak loads would skyrocket, requiring new investments in existing plants; or it might even damage system reliability. The absorbed financial risk would be too great. Regulators won't approve it. Customers won't pay for it.

Quashing the Misperceptions: Myths vs. Reality

If that's your reaction, you are not alone. These are what we consider the "myths." Once we challenged them, we found the reality often didn't match.

At Georgia Power, we decided specifically to challenge the stereotypes about flat pricing for small customers, both residential and small business. The result was a flat pricing pilot program rolled out June 1, 2000, which involved 500 customers. The goal of the program was to understand the myths about flat pricing.

On the surface, the idea of pure flat pricing in the electric market is frightening, posing potential threats in terms of capacity constraints, the price premium, revenue risk, and regulations. But under the microscope of market research, load shape modeling, and product testing, we found an exciting new pricing opportunity. Let's examine each of these perceived threats and the realities we came to understand.

Myth # 1: System Capacity Will Suffer.

The biggest hurdle to flat pricing in the energy industry is the fear that customers will change their behavior, which then will lead to a dramatic increase in their load demand. Although this worry is deeply held, we have been unable to find quantitative research to support it.

We used a three-prong approach to challenge this belief. First, customers were surveyed to learn how they would behave on such a pure flat program. Then those results were put through a modeling program that analyzed and projected the impact of these customers' behavior change on their load shape. Finally, we conducted a

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